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Gaps between subpart F income and PFIC classification

Today’s post is about a few gaps between taxation under the subpart F rules for controlled foreign corporations and passive foreign investment company (PFIC) rules. If your business happens to fall into one of these gaps (or can be reconfigured to fall into one of these gaps), it can be useful for deferring US taxes on income.

Complement between subpart F rules and PFIC rules

Congress enacted the subpart F rules, applicable to controlled foreign corporations (CFCs), to prevent US persons from conducting certain kinds of operations through a corporation organized in a tax haven to avoid or defer US taxes. The subpart F rules do so by forcing US persons who own at least 10% of the voting power of CFCs to report its share of the CFC’s profits as income every year, even if there is no distribution from the CFC. IRC §951(a).

But because CFC rules apply only to foreign corporations in which more than 50% of the shares are owned by 10% voting US shareholders, it used to be possible to avoid CFC rules by inviting foreign shareholders or dispersing shares among many US shareholders. To eliminate the financial incentives for deferring tax on certain kind of income by using a corporation in a tax haven that avoids CFC rules, Congress enacted the PFIC rules. See JCS-10-87, 1021.

Type of deferral that PFIC rules are meant to prevent

A PFIC is a foreign corporation that either has “too much” passive income or “too much” assets that generate passive income. IRC §1297(a). Passive income is defined as foreign personal holding company income, which refers to income such as interest, dividends, royalties, and gains from the sale of assets that produce passive income. IRC §§1297(b), 954(c). The definition is fairly intuitive: Interest, dividends, royalties, and gains from the sale of assets that produce passive income are income we associate with passive investments rather than active conduct of businesses.

PFIC rules are meant to catch certain kinds of income that Congress would like to tax as a foreign corporation receives it, but cannot under subpart F rules. This is why passive income is defined by reference to the foreign personal holding company income under subpart F rules, and it is why 10% voting US shareholders in CFCs do not treat shares in the CFCs as PFIC shares, even if the CFC satisfies the PFIC definition. IRC §1297(b), (d).

No anti-deferral for sales and service income held in tax havens under PFIC rules

Subpart F income–the type of income that is subject to annual US taxation in the hands of 10% voting US shareholders–includes several types of income (IRC §954(a)):

Foreign personal holding company income, which is income such as interest, dividends, royalties, rents, gains from the sale of assets that produce these types of income, and gains from certain assets that are typically investments;

Foreign base company sales income, which involves using related parties, one of which is incorporated in a tax haven country, to conduct sales and purchases to accumulate income in the tax haven;

Foreign base company services income, which involves using related parties, one of which is incorporated in a tax haven country, to provide services to accumulate income in the tax haven; and

Foreign base company oil and gas income.

The PFIC passive income is narrower than the types of income that are subject to subpart F rules: It only includes foreign personal holding company income. Suppose we have a foreign corporation that is not a CFC deriving income from sales, services, or oil and gas extraction. That corporation is free to use a tax haven to defer income with limited PFIC risks, because the sales, services, and oil and gas income are not passive income under the PFIC test.

There is just one catch: Cash and cash equivalents are passive assets, even if they are working capital. Notice 88-22. But if the foreign corporation owns substantial business assets, then it can accumulate significant amounts of profits as cash without risking becoming a PFIC.

As stated previously, passive income under the PFIC rules includes only foreign personal holding company income. But even for foreign personal holding company income, there are slight differences in the CFC definition of foreign personal holding company income and PFIC definition of passive income that create possibilities for deferral.

Liquidating a subsidiary

If a CFC liquidates a wholly-owned subsidiary, the gain is foreign personal holding company income. Reg. §1.954-2(e)(2)(i) The 10% voting US shareholders of the CFC are taxable on the profits from the gain, even if the CFC does not make any distributions.

By contrast, if a foreign corporation liquidates a wholly-owned subsidiary, the gain is probably not passive income because of a change of business exception. The result makes intuitive sense under PFIC rules: Foreign corporations should not fear having to reorganize their business or sell unprofitable businesses for fear of becoming PFICs, but it is odd that the CFC rules do not have a corresponding exception.

Certain related party payments

Suppose you have a Cayman Islands parent company as your business’s holding company. It has a wholly-owned subsidiary in the British Virgin Islands that holds all your business’s IPs. The IP holding subsidiary then licenses those IPs to the Cayman parent company’s wholly-owned operating subsidiaries around the world in exchange for royalties. What results?

Under the PFIC rules, the royalties are collected from a related person. As long as the operating subsidiaries are not using passive income to pay the royalties, the royalties would not be passive income either. IRC §1297(b)(2)(C).

If the Cayman parent company is a CFC, then all its wholly-owned subsidiaries are CFCs. Royalties would normally be foreign personal holding company income under subpart F rules. IRC §954(c)(1)(A). But there is an exception: if a CFC receives royalties from a related person, and the related person is not paying the royalties using subpart F income, then the royalties are not foreign personal holding company income either. IRC §954(c)(6).

The PFIC and CFC rules are consistent in this regard, with one odd difference: Under the CFC rules, the Code provision that excludes the royalties from foreign personal holding income is effective for years 2006 to 2019 only. IRC §954(c)(6)(C). This provision had older sunset dates in prior years, but Congress renewed the provision each time. If Congress does not renew the provision in a future session, then potentially the exclusion will go away under CFC rules, requiring 10% voting US shareholders to recognize income annually.

By contrast, the PFIC exception does not have a sunset date. The IP holding subsidiary will continue to avoid becoming a PFIC under the related party exception rules.

I used royalties as an example, but the same problem applies to dividends, interests, and rent received from a related person: The CFC exception to foreign personal holding company income has a sunset date. The PFIC exception to passive income lacks the sunset date.

Using these differences

In these situations, the differences between CFC rules and PFIC rules favor non-PFICs: The exclusions under PFIC rules are more generous than the ones for CFCs. The idea, then, is to avoid being treated as CFCs.

How you may avoid CFC classification depends on your business.

Suppose you intend to create a holding company in the Cayman Islands, Hong Kong, Ireland, or another low tax jurisdiction, and you intend to take the company public in a few years. There might not be so much engineering required: The company likely will cease to be a CFC once it goes public (too many shareholders). It is then free to reorganize subsidiaries and collect payments from related parties with low (though nonzero) risks under the PFIC rules. You just need to worry about capital gains being converted to dividends under section 1248 should you decide to sell your shares.

Suppose you intend to keep the company private instead, then you may never be rid of the CFC rules by dispersing shareholding. In this situation, it may be useful to seek out a foreign business partner to jointly own the business, so shares in the hands of 10% US voting shareholders do not exceed 50%.